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Medtronic Sets Pace for Future Growth

Medtronic Inc. (NYSE: MDT) is a leading medical device company that offers a spectrum of high-tech treatments for cardiovascular diseases, diabetes and neurological disorders. The cardiovascular group is the company's largest unit. Medtronic recently resolved long standing patent infringement issues with rival device maker, Edwards Lifesciences Corp. (NYSE: EW) .

Further, Medtronic is planning to acquire Ireland-based Covidien plc (NYSE: COV) . If the deal clears regulatory hurdles, Medtronic will be poised to advance its strategy of therapy innovation, globalization and creating economic value for its patients. In sum, all of these developments are good news for long-term investors in the medical technology sector.

Medtronic settles heart valve patent dispute with EdwardsAs has been reported, Medtronic and Edwards Lifesciences announced a resolution in May 2014 to patent disputes over transcatheter heart valves after a long and bitter legal imbroglio.

The agreement came shortly after the courts ruled in favor of Edwards – a ruling that could have impeded Medtronic's ability to offer U.S. patients its CoreValve replacements. In short, Medtronic will make an initial one-time payment to Edwards of $750 million, and then successive annual royalty payments of at least $40 million until April 2022.

John Liddicoat, president of the company's Structural Heart business said in a statement, "With this resolution, we are pleased that Medtronic will be able to continue to provide the CoreValve System, as well as other products, to patients who need them in the US and abroad."

The resolution was also timely for Edwards Lifesciences as it announced last month that the US Food and Drug Administration has approved Edwards' SAPIEN XT transcatheter aortic valve. The valve is designed for patients suffering from severe symptomatic aortic stenosis.

The big breakthrough here is the elimination of open heart surgeries for aortic valve replacements. That being said patients in Europe have been the beneficiaries of transcatheter valve replacements since 2010. Investors should also note Medtronic won FDA early approval for its CoreValve system in January 2014. So the settlement with Edwards Lifesciences clears the way for Medtronic to offer its patients this transcatheter replacement option.

Why Medtronic's acquisition of Covidien mattersMedtronic and Covidien plc announced in June an agreement which contemplates Medtronic's acquisition of Covidien in a cash-and-stock transaction valued at $93.22 per Covidien share, or a total of about $42.9 billion.

Ultimately the new entity will support three main strategies: therapy innovation, globalization, and economic value for patients. The synergies created by combining Covidien's research and development and manufacturing with Medtronic's clinical expertise will enable the new company "to provide a broader array of complementary therapies and solutions that can be packaged to drive more value and efficiency in health care systems."

There is another rationale for this alliance since this deal is also commonly known as an inversion which will result in a lower U.S. tax burden for Medtronic. It goes without saying that these transactions are controversial.

What isn't controversial is Medtronic's slow, steady growth. Net sales in the 2014 fiscal year were $17 billion, an increase of 3% percent from the prior fiscal year. This was driven primarily by 2% growth in Medtronic's Cardiac and Vascular Group, 2% growth in the Restorative Therapies Group, and an impressive 9% growth in the Diabetes Group compared to the 2013 fiscal year.

The bottom lineMedtronic has long been one of the largest medical technology companies with its array of therapies for treating cardiovascular diseases, diabetes, and neurological disorders. Covidien has also been a leading global health care technology and medical supplies provider. Despite critics' worries over the tax inversion angle, this marriage goes far deeper than that.

The new Medtronic's entity will have global reach and its newly approved CoreValve along with its line of pacemakers, defibrillators, and infusion therapies will reach patients across the global health care village.

In other words, the impressive sales figures for its array of devices noted in the annual report will be supported by this transaction. Moreover, the company is presently trading at a P/E ratio of 21 and a forward P/E of about 15. So it stands to reason that Medtronic is worth a look by investors in the medical device segment with a long-term view.

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Unfortunately the acquisition of Covidien will not be so good for shareholders (unless you are a Medtronic executive or board member who is going to "grossed up" at the cost of the shareholders).

In Deal to Cut Corporate Taxes, Shareholders Pay the Price

By STEVEN DAVIDOFF SOLOMON

July 8, 2014 7:03 pmJuly 8, 2014 7:35 pm 12 Comments

Medtronic is pursuing a deal to move abroad and save taxes. But few have noticed that the company’s shareholders will be the ones left with a big tax bill as a result.

Oddly, some of Medtronic’s largest shareholders — BlackRock, Vanguard and other mutual funds — may simply not care.

The Minneapolis-based Medtronic offered last month to buy Covidien of Ireland for $42.9 billion. When one company acquires another, the buyer’s shareholders typically do not pay taxes. The reason is simple: The buyer’s shareholders do not receive anything new, they simply keep holding shares in the buyer.

Yet things are different in this deal because Medtronic, like some other American companies, is pulling a tax maneuver known as an inversion.

As long as the shareholders of the foreign company own 20 percent or more of the combined entity, a company in the United States can adopt a new homeland for tax purposes as part of the acquisition, in that way lowering its taxes and permitting it access to cash held abroad.

Pharmaceutical and medical device companies like Medtronic are leading the rush to go abroad, but the trend is spreading. Chiquita Brands, the banana company, and Destination Maternity, a company that sells clothing for expectant mothers, are also seeking inversions, while Walgreen is contemplating such a move.

The Medtronic deal is the biggest one so far. The merger of medical device makers is structured so that Medtronic will relocate to Covidien’s corporate home in Ireland, where the corporate tax rate is lower than it is in the United States.

Both companies are in the medical device business, but analysts and investors have said the deal makes sense largely because Medtronic can tap its $12 billion in overseas cash without paying United States taxes.

The deal may be a win for Medtronic, but its shareholders will pay a price.

The Internal Revenue Service will treat the acquisition as if Medtronic shareholders had sold their shares. Under I.R.S. rules, when a company moves abroad in a tax inversion, the buyer’s shareholders must pay capital gains if they will hold 50 percent or more of the shares.

That is the case for Medtronic, and so its shareholders will be stuck with that big tax bill — up to 33 percent in California after you include the state tax. (In Minnesota, where the top capital gains tax is 7.9 percent, shareholders may pay up to 29.7 percent of their holdings in tax.)

Let’s pause and reflect that Medtronic is pushing a transaction that from Day 1 may cost some of its shareholders as much as 33 cents on the dollar.

The sand in the eye for the shareholders is that Congress tried to halt the tide of inversions about a decade ago. Lawmakers amended the tax code to provide that executives of companies like Medtronic that went abroad would have to pay a tax on their stock compensation. The tax is at the same capital gains tax that Medtronic’s shareholders will have to pay in connection with the transaction.

But unlike its shareholders, Medtronic’s executives will be “grossed up” by the company. Medtronic will spend millions to pay the tax obligations of its executives in connection with the transaction. At least seven other companies undertaking inversions have indemnified their executives to the tune of tens of millions of dollars, according to Bloomberg News.

But shareholders will receive nothing from Medtronic.

The gross-up highlights the absurdities of some Washington tax policies. Congress initially acted to halt inversions, but succeeded only in costing shareholders more as their companies just pay the tax for executives.

The real question is why shareholders at Medtronic and other companies haven’t protested. After all, Medtronic’s shareholders will get to vote on this deal.

One reason may be that inversions do have benefits for shareholders. By lowering the company’s tax rate, its stock price will readjust to reflect these additional earnings.

Still, giving up a third of their value to endorse this transaction and reap benefits down the road seems like quite a sacrifice to ask of shareholders.

And yet Medtronic, like other companies, has been silent on the benefits to shareholders. Medtronic extolled the $850 million in savings and benefits it estimated it could reap from a combination with Covidien, but it said nothing of how much it would save on taxes.

A representative for Medtronic said that the Covidien acquisition was being driven by strategic reasons, not tax considerations, and would create long-term value for shareholders. He also said that the company was covering the excise tax for executives and directors “because they should not be discouraged from taking action that they believe is in the best interests of Medtronic and its shareholders.”

Medtronic is following the herd. Companies undertaking inversions say as little as possible on the tax issues mainly to avoid Washington’s scrutiny. Tax inversions are typically announced with a note in the news release that the new corporate home will be abroad — the rest of the release simply talks about how great the strategic aspects of the deal are, ignoring the fact that the entire transaction rests on this tax move.

So why would shareholders support the Medtronic acquisition? Rational shareholders would conceivably demand that Medtronic show that the returns for going abroad will exceed 33 cents on the dollar that some may have to pay. This is particularly true when executives are getting partially covered by the company.

But the quirks of the market mean that shareholders aren’t always rational.

The bulk of Medtronic’s shares are held by mutual funds. They hold 78.22 percent of Medtronic’s shares, according to Standard & Poor’s Capital IQ. The investing public holds only 14.64 percent. The top 10 holders include BlackRock, the largest with 6.5 percent of the shares.

Mutual funds don’t seem to care much about taxes. The reason may be that when the returns of BlackRock and others are calculated, the taxes aren’t included. These are pesky bills paid by the holders of BlackRock’s funds. Shareholders only get the bill at the end of the year, and the total taxes are mixed with all other trading. So perhaps shareholders don’t complain because they either don’t notice or because the overall effect on them appears to be too small.

Proxy advisory services like Institutional Shareholder Services also don’t take taxes into account, with the justification that taxes are too individualized to make a general recommendation.

Institutions have no incentive to complain about the tax situation in this deal. And they don’t.

Institutional investors capture only the upside of inversions. They get to show higher returns in their portfolio from the lower taxes and higher stock prices. But the tax consequences are borne privately by shareholders.

BlackRock did not respond to a request for comment.

As for Medtronic, the executives who do care about their taxes will have much of that bill paid by the company. Its shares, meanwhile, will receive a pump in value that will enhance executive pay packages based on stock compensation. And the executives get much of their taxes paid by Medtronic. The costs to shareholders are ignored.

You have to shake your head. Medtronic is taking advantage of two tax loopholes here. One is the move abroad. The second, less-noticed advantage makes shareholders unlikely to protest that they are paying huge sums to subsidize the gains of Medtronic’s executives.

Only in America.

Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, is the author of “Gods at War: Shotgun Takeovers, Government by Deal and the Private Equity Implosion.” E-mail: dealprof@nytimes.com | Twitter: @StevenDavidoff

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Kyle is a Long Island based writer and a Motley Fool contributor since January 2013.
He has a broad background in the financial sector. His business and political writing
is widely available on the web.